Foreign Aid

By Deepak Lal

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Foreign aid as a form of capital flow is novel in both its magnitude and its global coverage. Though historical examples of countries paying “bribes” (see below) or “reparations” to others are numerous, the continuing large-scale transfer of capital from rich-country governments to those of poor countries is a post–World War II phenomenon. The origins of these transfers lie in the breakdown of the international capital market in the period between the two world wars and in the rivalry for political allies during the cold war.

The breakdown of the international capital market provided the impetus for the creation of the World Bank at Bretton Woods. Its purpose was to provide loans at market interest rates to poor countries that were shut out of Western capital markets—especially the largest, the United States—because of their widespread defaults in the 1930s and the imposition of the U.S. government’s “blue sky” laws, which forbade U.S. financial intermediaries to hold foreign government bonds. Meanwhile, European markets were closed through exchange controls; the United Kingdom, for example, had its exchange controls until 1979. Official loans to poor countries at commercial interest rates, as laid down in the charter of the World Bank’s parent, the International Bank for Reconstruction and Development, would have been justified purely on efficiency grounds to intermediate the transfer of capital from where it was less scarce to where it was scarcer.

This purely economic case was buttressed by political and, later, humanitarian justifications for concessional official flows, that is, loans with softer—that is, concessional—terms on interest and repayment. As to the political reasons for giving aid, little can be added to Lord Bauer’s devastating critique (Bauer 1976) that, instead of fostering Western political interests, foreign aid abetted the formation of anti-Western coalitions of Third World states seeking “bribes” not to go communist. A statistical study concluded that “as an instrument of political leverage, economic aid has been unsuccessful” (Mosley 1987, p. 232). The end of the cold war has removed this political motive. Currently, advocates of foreign aid emphasize the humanitarian and economic cases, though each rationale has seen many metamorphoses.

The humanitarian case for concessional flows was based on an analogy with the Western welfare state. The idea was that just as many people favor welfare to transfer wealth from the relatively rich to the relatively poor within a country, so they favor welfare to transfer wealth from relatively rich countries to relatively poor ones. But many commentators not necessarily hostile to foreign aid—I. M. D. Little and J. Clifford, for example (Little and Clifford 1965)—emphasized that the humanitarian motives for giving aid may have justified transferring Western taxpayers’ money to poor people, but not to poor governments: the latter may have no effect on the former. With the likes of Marcos of the Philippines, Bokassa of the Central African Republic, Abacha of Nigeria, and a host of other kleptocratic “tropical gangsters” in power (Klitgard 1990), the money may simply be stolen. According to William Easterly, despite over $2 billion in foreign aid given to Tanzania’s government for roads, the roads did not improve. What increased was the bureaucracy, with the Tanzanian government producing twenty-four hundred reports a year for the one thousand donor missions that visited each year.1 Nor can the poor of the world claim a moral right to welfare transfers from the rich. While recipients of domestic welfare payments depend on the existence of a national society with some commonly accepted moral standard, there is no similar international society within which a right to aid can be established (Lal 1978, 1983).

The vast majority of foreign aid has failed to alleviate poverty. It has improved the lot of poor people in a few cases. The people of Martinique, for example, are probably better off because the French government provides a very high percentage of their gross domestic product. Also, foreign aid helped wipe out river blindness in West Africa, keeping eighteen million children safe from infection.2 But a statistical study found that foreign aid “appears to redistribute from the reasonably well-off in the West to most income groups in the Third World except the very poorest” (Mosley 1987, p. 23). This is consistent with the evidence from both poor and rich countries that the middle classes tend to capture government transfers (see redistribution). By contrast, private transfers through either traditional interfamily channels or private charities (nongovernmental organizations, or NGOs) are more efficient in targeting these transfers to the poor, as well as in delivering health care and education (Lal and Myint 1996). The centralized bureaucracies of the Western aid agencies are particularly inept in targeting these transfers to the truly needy because they lack local knowledge. Moreover, there is evidence that these inefficient public transfers tend to crowd out more efficient private transfers (Lal and Myint 1996). Not surprisingly, therefore, despite their claim that their mission is to alleviate Third World poverty, official aid agencies are increasingly subcontracting this role to the NGOs. Whether this official embrace of the NGOs is in the NGOs’ long-term interest is arguable (Lal 1996).

The political and humanitarian justifications for foreign aid are in tatters. What of the purely economic case? One such case was the “two-gap theory,” the idea that foreign aid was required to fill one of two shortfalls—in foreign exchange or savings—that depressed the growth rates of developing countries below some acceptable limit (Lal 1972). The alleged “foreign exchange” gap was based on dubious assumptions. One such assumption was “export pessimism,” the idea that poor countries would not generate many exports. Many development economists held this view despite a paucity of evidence for it (Lal 2002). Because both experience and theory have shown the irrelevance of this assumption, the “foreign exchange gap” justification for foreign aid has lost all force.

Nor has the “savings gap” justification proved to be any more cogent. Contrary to the theory that foreign capital is necessary to supplement fixed and inadequate domestic savings, the savings performance of developing countries in the post–World War II period shows that nearly all of them (including those in Africa until the early 1970s) have steadily raised domestic savings rates since the 1950s (Lluch 1986). Moreover, a study of twenty-one developing countries between 1950 and 1985 confirms the commonsense expectation that differences in economic growth rates are related more to differences in the productivity of investment than to differences in investment levels (Lal and Myint 1996). Finally, statistical studies of the effects of foreign aid on growth and poverty alleviation have not been favorable (Easterly 2001). One found that, after correcting for the link between aid and income levels and growth, the effect of aid on growth is often negative (Boone 1994) (see Figure 1). A survey of other such studies concludes that “there is now widespread skepticism that concessional assistance does have positive effects on growth, poverty reduction or environmental quality” (Gilbert et al. 1999, p. F607).

Figure 1 Foreign Aid and Growth Across Countries, 1960-2002

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Source: William Easterly

Except for sub-Saharan Africa, the World Bank finances less than 2 percent of investment in developing countries (Krueger 1998). Most of its lending continues to finance projects. The rates of return of more than 10 percent earned by these projects are not a measure of the true effects of the aid provided, because money is fungible. A government can use aid to finance a high-yielding project that it would have undertaken in any case, and then use its own resources to finance a project with a low rate of return (say, more armaments). This problem led to the growth of “program” lending, which expanded in the 1980s along with the growth of “structural adjustment” loans. Program loans were based on a mutually agreed overall economic program by the recipient government. Structural adjustment loans were given in return for specific commitments made to alter particular policies that damaged economic efficiency. Advocates of such loans hoped that by applying conditions to the program loans they could give the governments an incentive to implement better policies, by, for example, avoiding price controls, moving toward free trade, and reducing high marginal tax rates. That way, these advocates believed, foreign aid would improve economic conditions. But numerous studies have found that

policy conditionality is ineffective. Not only is aid not necessarily used for what it is directly intended, but also, on average, it has no effect on growth, either directly, or indirectly through improved government policies. What matters is the policy environment, but lending appears to have little direct impact on this. (Gilbert et al. 1999, p. F619)

This is hardly surprising. As the adage has it, “You can lead a horse to the water, but you can’t make him drink.” Governments make all sorts of promises to get the loan, but then renege on them once they have taken the money, as President Moi of Kenya demonstrated repeatedly in the 1980s. Moreover, the aid agencies do not call their bluff, for they are part of a large international business in “poverty alleviation” from which a large number of middle-class professionals derive a good living. These “Lords of Poverty” (Hancock 1989) depend on lending as much as possible and persuading the public in rich countries that these loans will alleviate poverty. It is in the mutual interest of both the Lords of Poverty and the recalcitrant poor country governments to turn a blind eye to the nonfulfillment of the conditions on policy changes.

The latest justification for foreign aid is that, as the current ex-ante conditionality has failed, ex post conditionality should be used instead. In other words, rather than seeking promises for better future actions, governments should be judged by their past actions, and only those whose past policy environment has been better than that of their peers should receive “aid.” According to this rationale, not only will the laggards have a greater incentive to improve their policies, but aid will also be more effective. There are two problems with this justification. The whole economic argument in favor of aid was to improve the economic performance of countries unable to help themselves. If the basket cases are to be left behind because of their predatory governments, what happens to the humanitarian arguments in support of aid? Second, and more important, with the opening of the world’s capital markets to well-run developing countries, what incentive do these countries have to turn to the aid agencies—and their onerous procedures and conditions for loans—when they can borrow much more easily from a syndicate put together by the likes of Goldman Sachs? Any “neighborhood effects” whereby well-run countries are shunned by private capital markets because of their neighbors (as is claimed for Africa) can be readily countered by the aid agencies providing credit ratings for countries, just as Moody’s does for the private sector. The large research capacity and information governments provide to the aid agencies would lend credibility to these ratings. No loans would be required.

The foreign aid programs of the last half century are a historical anomaly. They are part and parcel of the disastrous breakdown of the nineteenth-century liberal economic order during the interwar period. But just as a new liberal economic order is gradually being reconstructed—with a milestone being the collapse of the Soviet Union and its allies and their growing integration into the world economic order—the various palliatives devised to deal with the dreadful woes bred by the past century’s economic breakdown are becoming more and more redundant. Whether or not there was ever a time for foreign aid, it is an idea whose time has gone.

About the Author

Deepak Lal is James S. Coleman Professor of International Development Studies, University of California at Los Angeles, and professor emeritus of political economy, University College London. He was a full-time consultant to the Indian Planning Commission (1973–1974) and has served as a consultant to the ILO, UNCTAD, OECD, UNIDO, the World Bank, and the ministries of planning in Korea and Sri Lanka. He has been a member of the U.K. Shadow Chancellor’s Council of Economic Advisors since 2000, and a distinguished visiting fellow at the National Council for Economic Research, New Delhi, since 1999.

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